Financial Management I Exam: Sections A And B Questions ✓ Solved

FINANCIAL MANAGEMENT I EXAM: SECTION A AND SECTION B QUESTI

FINANCIAL MANAGEMENT I EXAM: SECTION A AND SECTION B QUESTIONS

Section A: Joanna purchases a car valued at $2,000,000. She earns a monthly salary of $250,000 and wants her monthly loan payment to be below 25% of salary. CIBC offers 90% financing for 3 years at 8% compounded monthly. Scotiabank offers 100% financing for 3 years at 12% compounded monthly. Payments are due at the end of each month.

A. Prepare amortization schedules for both loans.

B. Which company should Joanna accept based on her constraint and why?

Three months into the loan Joanna accepted a line of credit with a $650,000 limit. The line has no interest when unused, but charges 30% interest compounded monthly on any outstanding balance. She lost income for two months and was unable to make monthly payments. She borrowed from the line of credit to avoid default. A month later she returned to work and hopes to settle the outstanding sum.

C. What is the Effective Annual Rate (EAR) on the credit line?

D. Recommend the amount outstanding for the two months, including the interest on the credit line if her loan had been from CIBC.

Section B: Answer any two of the following questions.

Question 1: Ken has been investing $1,000 at the end of each month at 12% annual nominal (monthly compounding) for the past two years. He planned a $30,000 vacation this year and wants to buy a car in five years and reach $250,000 by investing at 12% annually. He purchased an investment at 6% that pays cashflows: $1,000 at each of the next three years, $2,000 at end of year 4, $3,000 at end of year 5 and $5,000 at end of year 6.

A. Would Ken have succeeded with his vacation investment?

B. How much should he have invested monthly to reach $30,000?

C. How much should he invest now to reach $250,000 in five years?

D. What is the total cashflow of the 6% investment and its present value?

Question 2: Levi Company Ltd: Last dividend was $2.50. Dividends grow 10% for the next 2 years, 8% in year 3, and 6% thereafter. Required return is 12%. Current stock price is $49.75. The company also has a $20 million bond issue at $1,000 par with 25 years to maturity (as of January 2020), semiannual coupon 6% and yield to maturity originally 8%; after a downgrade bonds with similar risk require 12% YTM.

A. Determine the current market value of the stock.

B. How much is the change in the value of the bond after the downgrade?

C. Summarize the client's investments.

Paper For Above Instructions

Section A — Joanna's car financing decisions and line of credit implications

1) Loan computations and amortization summaries

Parameters and monthly payments:

  • CIBC: Loan = 90% of 2,000,000 = 1,800,000; annual rate = 8% compounded monthly → monthly r = 0.08/12 = 0.006666667; n = 36 months. Monthly payment PMT = PV * r / (1 − (1+r)^(−n)) ≈ JMD 56,407. Total paid over 36 months ≈ 56,407 × 36 = 2,030,649. Total interest ≈ 230,649 (on principal 1,800,000) (Ross et al., 2019).
  • Scotiabank: Loan = 100% of 2,000,000 = 2,000,000; annual rate = 12% compounded monthly → monthly r = 0.12/12 = 0.01; n = 36. Monthly payment PMT ≈ JMD 66,524. Total paid ≈ 66,524 × 36 = 2,394,864. Total interest ≈ 394,864.

Amortization schedule (illustrative first three months and totals):

CIBC (loan 1,800,000, r=0.0066667, PMT ≈ 56,407):

  • Month 1: Opening balance 1,800,000; Interest = 1,800,000×0.0066667 ≈ 12,000; Principal = 56,407 − 12,000 = 44,407; Closing balance ≈ 1,755,593.
  • Month 2: Opening 1,755,593; Interest ≈ 11,704; Principal ≈ 44,703; Closing ≈ 1,710,890.
  • Month 3: Opening 1,710,890; Interest ≈ 11,406; Principal ≈ 44,999; Closing ≈ 1,665,891.
  • Totals: 36 payments of ≈56,407; total interest ≈230,649; loan fully amortized at month 36.

Scotiabank (loan 2,000,000, r=0.01, PMT ≈ 66,524):

  • Month 1: Interest = 20,000; Principal ≈ 46,524; Closing ≈ 1,953,476.
  • Month 2: Interest ≈ 19,535; Principal ≈ 46,989; Closing ≈ 1,906,487.
  • Month 3: Interest ≈ 19,065; Principal ≈ 47,459; Closing ≈ 1,859,028.
  • Totals: 36 payments ≈66,524; total interest ≈394,864; loan amortized at month 36.

2) Recommendation based on Joanna's constraint

Joanna wishes payments below 25% of monthly salary: 25% × 250,000 = 62,500. The CIBC monthly payment (~56,407) is below 62,500; the Scotiabank payment (~66,524) exceeds 62,500. Therefore CIBC meets her budget constraint and is the recommended lender (Brigham & Ehrhardt, 2019).

3) Effective Annual Rate (EAR) on the line of credit

Monthly nominal rate = 30% annually ⇒ monthly r = 0.30/12 = 0.025. EAR = (1 + 0.025)^12 − 1 ≈ 0.3447 ≈ 34.47% per year. This is a very high effective rate and signals that using the line for more than a month is costly (Bodie, Kane & Marcus, 2014).

4) Outstanding amount after two missed payments financed by the line (CIBC scenario)

Under the CIBC loan Joanna's monthly payment ≈ 56,407. If she misses two payments she will need ~112,814 (2 × 56,407) borrowed on the line. If she repays the LOC one month later, one month of interest at 2.5% applies: Outstanding = 112,814 × (1 + 0.025) ≈ 115,634. Interest charged ≈ 2,820. Therefore Joanna should expect to settle ≈ JMD 115,634 to retire the LOC borrowing used to cover the two missed payments. Given the high EAR, she should pay it off immediately (Investopedia, 2020).

Section B — Selected questions: Question 1 and Question 2

Question 1 (Ken):

A. Success with vacation investment: Ken invested 1,000 per month for 24 months at monthly r = 0.12/12 = 0.01. Future value FV = 1,000 × ((1.01^24 − 1)/0.01) ≈ 1,000 × 26.959 ≈ 26,959. This is short of his 30,000 vacation goal; he would not have succeeded (Hull, 2018).

B. Required monthly deposit for FV = 30,000 in 24 months at 1% monthly: PMT = FV × r / ((1+r)^n − 1) = 30,000 × 0.01 / 0.26959 ≈ 1,113 per month. He needed to save about JMD 1,113 monthly.

C. Lump-sum now to reach 250,000 in five years at annual 12%: PV = 250,000 / (1.12^5) ≈ 250,000 / 1.7623 ≈ 141,762. He should invest ≈ JMD 141,762 now (Brealey, Myers & Allen, 2017).

D. Total cashflow and present value of the 6% investment: Total nominal cashflow = 1,000×3 + 2,000 + 3,000 + 5,000 = 13,000. Discounted at 6%: PV ≈ 1,000/1.06 + 1,000/1.06^2 + 1,000/1.06^3 + 2,000/1.06^4 + 3,000/1.06^5 + 5,000/1.06^6 ≈ 10,023. The investment's PV (~10,023) is less than its nominal total and should be evaluated against alternative uses of capital (Ross et al., 2019).

Question 2 (Levi Company Ltd):

A. Intrinsic stock value using a 3‑stage dividend model. D0 = 2.50.

  • D1 = 2.50×1.10 = 2.75
  • D2 = 2.75×1.10 = 3.025
  • D3 = 3.025×1.08 = 3.267
  • D4 = D3×1.06 = 3.462

Terminal value at t=3: P3 = D4/(k − g) = 3.462 / (0.12 − 0.06) ≈ 57.70. Present value: PV = 2.75/1.12 + 3.025/1.12^2 + (3.267 + 57.70)/1.12^3 ≈ 48.27. The market price 49.75 exceeds intrinsic value ≈48.27, suggesting the stock is mildly overvalued relative to this model (Damodaran, 2020).

B. Bond value change after downgrade: For a $1,000 par bond, semiannual coupon = 30 (6% annual). At original YTM 8% (semiannual 4%), price ≈ 785.17. At new YTM 12% (semiannual 6%), price ≈ 527.16. Decline per bond ≈ 258.01. For $20 million par (20,000 bonds), total decline ≈ 258.01 × 20,000 ≈ 5,160,200. This is a material loss in market value driven by increased required yield after the downgrade (Fabozzi, 2016).

C. Summary: The stock valuation shows a modest overpricing relative to intrinsic DDM value. The bond portfolio suffered a substantial mark-to-market loss due to the downgrade and higher yields. The client’s portfolio has interest-rate and credit-risk exposure; rebalancing or considering credit risk hedges is prudent (CFA Institute, 2020).

References

  • Brigham, E. F., & Ehrhardt, M. C. (2019). Financial Management: Theory & Practice. Cengage Learning.
  • Ross, S. A., Westerfield, R. W., & Jaffe, J. (2019). Corporate Finance. McGraw-Hill Education.
  • Bodie, Z., Kane, A., & Marcus, A. J. (2014). Investments. McGraw-Hill Education.
  • Brealey, R. A., Myers, S. C., & Allen, F. (2017). Principles of Corporate Finance. McGraw-Hill Education.
  • Investopedia. (2020). Effective Annual Rate (EAR) Definition. Retrieved from https://www.investopedia.com
  • Damodaran, A. (2020). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley.
  • Fabozzi, F. J. (2016). Bond Markets, Analysis and Strategies. Pearson.
  • CFA Institute. (2020). Equity Asset Valuation. CFA Institute Publications.
  • Hull, J. (2018). Options, Futures, and Other Derivatives. Pearson.
  • McDonald, R. L. (2016). Derivatives Markets. Pearson.

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